What Is Naked Shorting?
Naked shorting is the illicit practice of selling shares of a security without first borrowing or arranging to borrow them, and then failing to deliver them to the buyer by the settlement date. It is a highly controversial practice within securities trading, as it can create "phantom shares" in the market, potentially distorting supply and demand dynamics. Unlike traditional short selling, where a seller borrows shares before selling them with the expectation of repurchasing them later at a lower price, naked shorting bypasses this crucial borrowing step. Regulators, such as the Securities and Exchange Commission (SEC), have implemented rules to prevent naked shorting due to its potential for market manipulation and systemic risk. A market maker, typically involved in facilitating trading, usually has exemptions in traditional short selling, but these do not extend to intentional naked shorting.
History and Origin
The issue of naked shorting has existed alongside traditional short selling, but it gained significant regulatory attention following periods of heightened market volatility and alleged manipulation. While the practice of selling shares without immediately possessing them could sometimes occur due to operational inefficiencies in the past, intentional naked shorting for manipulative purposes became a greater concern. The ability for a seller to sell shares they do not own and cannot deliver can artificially inflate the supply of a stock, theoretically driving down its price.
One prominent case that brought naked shorting into public discourse involved Overstock.com. Beginning in the mid-2000s, the company's CEO publicly alleged that certain prime brokerage firms engaged in illegal market manipulation through naked short selling, which he claimed significantly depressed Overstock's stock price. The protracted legal battle resulted in settlements, highlighting the complexities and accusations surrounding the practice.4 These events, among others, spurred regulators to strengthen rules aimed at curbing abusive naked shorting practices.
Key Takeaways
- Naked shorting involves selling shares that have not been borrowed or located, with the intention of delivering them at a later date, often leading to failures to deliver.
- It differs from legal short selling, where shares are first borrowed from a lender.
- The practice is generally prohibited by securities regulators globally due to its potential for market manipulation.
- Regulation SHO in the U.S. aims to prevent naked shorting by requiring broker-dealers to have a reasonable belief that shares can be located and delivered.
- Instances of naked shorting can lead to significant regulatory fines and legal action against involved parties.
Interpreting Naked Shorting
When naked shorting occurs, it manifests as a "fail-to-deliver" (FTD) in the clearing and settlement process. An FTD indicates that a seller was unable to deliver the promised shares to the buyer by the required settlement date (typically T+2, meaning two business days after the trade date). While FTDs can arise from legitimate operational issues, a sustained pattern or high volume of fails-to-deliver in a particular security can be a red flag for potential naked shorting. Regulators monitor FTD data to identify potential abusive practices. The presence of phantom shares created by naked shorting can disrupt the natural forces of supply and demand, potentially causing unwarranted downward pressure on a stock's price and impacting the accuracy of market pricing.
Hypothetical Example
Imagine Company X has 10 million shares outstanding. A traditional short seller would identify a broker-dealer willing to lend them shares of Company X, pay a stock loan fee, and then sell those borrowed shares.
In a naked shorting scenario, an illicit trader, without borrowing any shares of Company X, simply places a sell order for 100,000 shares of Company X stock. They do not possess these shares, nor have they confirmed their ability to borrow them. When the trade is executed, they are obligated to deliver the shares within the standard settlement period. If they fail to acquire and deliver these shares by the deadline, it results in a fail-to-deliver. This creates a situation where 100,000 shares exist on paper in the buyer's account, but no corresponding physical shares were ever truly transferred from the seller, effectively creating "phantom" shares in the market. The broker-dealer facilitating the trade may face regulatory consequences for not ensuring a proper "locate" of the shares.
Practical Applications
Naked shorting is primarily observed in the context of regulatory enforcement and market surveillance, as it is largely prohibited. Regulators continuously implement and refine rules to detect and penalize instances of naked shorting to maintain market integrity. For example, the SEC's Regulation SHO in the United States includes provisions like the "locate" requirement, which mandates that broker-dealers must have reasonable grounds to believe that a security can be borrowed and delivered before executing a short sale. Furthermore, it imposes "close-out" requirements for persistent fails-to-deliver.
Globally, other financial authorities also take action against illegal short-selling practices. For instance, South Korea's financial regulator has imposed significant fines on major investment banks for violating short-selling rules, including instances of naked short selling, underscoring the worldwide effort to combat this illicit activity.3 These regulatory actions serve as a critical tool for investor protection and to prevent market manipulation.
Limitations and Criticisms
While regulatory bodies strive to eliminate naked shorting, critics argue that it remains a challenge due to various loopholes, operational complexities, and the sheer volume of daily trading. One of the main criticisms is that intentional naked shorting can artificially deflate a company's stock price, potentially harming legitimate businesses by making it difficult for them to raise capital or leading to unwarranted financial distress. Some commentators suggest that it can exacerbate market volatility and undermine fair price discovery.
However, academic research on the direct market impact of fails-to-deliver (which can stem from naked short selling) presents varied conclusions. Some studies indicate that while fails-to-deliver occur, their broader impact on market quality, such as liquidity and pricing efficiency, might not always align with the most severe criticisms, suggesting that other factors might be at play or that regulatory measures have limited pervasive effects on the overall market.2 Nevertheless, regulators consistently emphasize the need to prevent abusive naked short selling to maintain confidence in the financial markets.
Naked Shorting vs. Short Selling
The key distinction between naked shorting and traditional short selling lies in the borrowing of shares.
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Short Selling: Involves borrowing shares from a lender (e.g., a broker-dealer) and then selling them. The seller must have a confirmed borrow of the shares before the sale is executed. The goal is to profit from a decline in the stock price by repurchasing the shares at a lower price later and returning them to the lender, thus closing the borrowed position. This is a legal and common trading strategy.
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Naked Shorting: Involves selling shares that the seller does not own, has not borrowed, and has not even confirmed the ability to borrow. The seller effectively creates a "phantom" share that must eventually be delivered, often leading to a "fail-to-deliver" if they cannot acquire the shares in time. This practice is largely illegal and is considered a form of market manipulation because it can create an artificial supply of shares.
The critical difference is the upfront "locate" and borrowing requirement. Traditional short selling is a regulated activity aimed at profiting from a price decline, whereas naked shorting bypasses established rules and can lead to undisclosed liabilities and market distortions.
FAQs
Is naked shorting legal?
No, naked shorting is largely illegal in the United States and many other jurisdictions. Regulations like the SEC's Regulation SHO prohibit the practice by requiring broker-dealers to ensure they can locate and deliver shares before a short sale is executed.1
How does naked shorting affect the market?
Naked shorting can create an artificial supply of shares, potentially putting unwarranted downward pressure on a stock's price. This can disrupt normal supply and demand dynamics, affect price discovery, and raise concerns about market manipulation and integrity.
What are "fails-to-deliver" in relation to naked shorting?
A "fail-to-deliver" occurs when a seller does not deliver the shares to the buyer by the settlement date. While FTDs can happen for legitimate reasons, a significant or persistent volume of FTDs in a security can indicate that illegal naked shorting may be taking place.
Can individual investors engage in naked shorting?
No. Naked shorting is a complex and illegal activity, typically associated with sophisticated market participants who attempt to exploit loopholes or engage in deceptive practices. Individual investors using standard brokerage accounts are generally prevented from naked shorting due to automated systems and regulatory requirements that ensure shares are borrowed before a short sale is executed.
What are the consequences of engaging in naked shorting?
Engaging in illegal naked shorting can result in severe penalties, including substantial fines, disgorgement of profits, trading bans, and even criminal charges for individuals and firms involved. Regulators aim to protect markets from such manipulative trading strategies and ensure fair practices for all investors. It can also lead to significant borrowing costs if the shares eventually need to be bought in a rising market to cover the position, along with potential legal liabilities.